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OPINION

NYSE welcomes digital insurer Lemonade

NYSE welcomes digital insurer Lemonade
July 1, 2020
NYSE welcomes digital insurer Lemonade

The New York Stock Exchange is set to welcome online insurer Lemonade Inc. (US:LMND) after it announced its intention to raise up to $286m (£229m) through an initial public offering that values the company at around $1.40bn when pitched at the upper end of the $23-$26 guide price range.

It may not be an opportune moment for tech stock flotations following the recent travails of Wirecard AG (GER:WDI), but the guide price represents a significant discount to Lemonade’s last private fundraising. This seems curious given the hype surrounding the stock, but it has a limited trading history and a relatively untried business model.

Some of the stock’s backers, most notably Japan’s SoftBank (JAP:9984), might beg to differ on that last point. The insurer has increased the value of gross written premiums from $9m in 2017 to $116m two years later, with another $38m underwritten in the first quarter of this year. Impressive on the face of it, although net losses quadrupled over the same period.

The bare figures can only tell us so much; rapid growth combined with a deteriorating bottom line should not set any alarm bells ringing at this stage. The central consideration is whether Lemonade’s business model provides any material advantages to its policyholders (or 'subscribers') which differentiate it from the growing number of tech start-ups targeting the millennial insurance market. Around 70 per cent of its existing customer base is aged 35 or under. The subscription service is pitched at renters and homeowners and is currently licensed in 41 US states and is expanding into Germany and the Netherlands. Part of the idea is that upsells will be generated as renters graduate to home ownership, although many young people are struggling to make the transition.

Lemonade is employing algorithms at every stage of the insurance process – underwriting, actuarial and claims – with a range of annoying chatbots to help customers through an online exchange that can be finalised in a matter of minutes. A streamlined digital approach offers price benefits to subscribers, but given the increased losses, it may be that the underwriting process needs a little fine tuning – time will tell.

While I do not pretend to understand the algorithms, it surely would not be too problematic for an insurer with established commercial channels to simply reproduce the software. It is possible that Lemonade will become a takeover target long before it turns a profit.

The main difference from its digital rivals is its financial model. Conventional insurance companies generate profits through a surplus of premiums over the claims they pay out to policyholders (ex-operating expenses). Lemonade simply takes 25 per cent of all premium income from the policy commencement date, leaving the remainder to settle claims. Anything left over from the claims process is given to charities chosen by its customers.

This last point is worth dwelling upon, particularly as claims can be processed in three minutes flat. The company’s founders, Daniel Schreiber and Shai Wininger, believe that this arrangement will act as a deterrent against fraudulent claims, as punters would be far less inclined to diddle a charity than a corporation. The incidence of fraud remains an ongoing risk factor for insurers, digital or otherwise, and we simply cannot tell whether their faith in human nature is justified.

To partially negate insurance regulatory requirements on surplus capital, the company cedes three-quarters of its premiums to reinsurers in exchange for a 25 per cent commission. This practice expands the proportion of premiums to reserves from a possible 2:1 (or 50c in the dollar) to 7:1. This has the added benefit of shielding the gross margin, but the effect is that in normal (ie 'non-catastrophic') years, when premiums outstrip claims, most of underwriting profits generated will go to Lloyds of London and any other reinsurers involved.

Softbank has had a rough trot in terms of its preferred tech candidates of late, but Messrs Schreiber and Wininger have other heavyweight backers such as Allianz SE (Ger:ALV) and Alphabet Inc’s (US:GOOGL) venture capital arm. Impressive company to be sure, although I think you still might be better foregoing Lemonade in favour of a beer when the pubs reopen.